No ‘sock puppet’? What to expect from Trump’s pick for the Fed chair

The question of whether Kevin Warsh will do what Donald Trump wants if he becomes chairman of the US Federal Reserve Board was always going to central at his confirmation hearing on Tuesday.

What did we learn? He denied, repeatedly, that he would be a “sock puppet” for Trump, saying that the US president had never pressured him to lower rates if he were confirmed as chair.

“The president never asked me to predetermine, commit, fix, decide on any interest rates in any of our discussions, nor would I ever agree to do so,” Warsh said. “The president never generally or specifically instructed me … suggested I should commit to any interest path whatsoever.”

Trump was asked last week in an interview with Fox Business, whether he expected interest rates to fall this year.

“When Kevin gets in, I do, yeah,” he responded.

Just before Warsh’s hearing, he said he would be “disappointed” if Warsh didn’t reduce interests once he had been confirmed as the new central bank chair.

‘When Kevin gets in, I do [expect rates to fall this year], yeah.’

Donald Trump in a Fox Business interview

During the selection process to choose the successor to the incumbent chair, Trump’s bête noire Jerome Powell, the president made it very clear that he wouldn’t appoint anyone who wasn’t going to lower rates. He also expected his nominee to consult with him on rate decisions.

Warsh, however, repeatedly denied he had made any deal with Trump to gain the nomination. In his opening statement, he said he didn’t believe the operational independence of monetary policy was threatened when elected officials, including the president, stated their views on interest rates.

“I’ve heard his view on interest rates, and it sounded very similar to me to every other president in economic history,” he said.

The difference between Trump and other presidents, however, is that where others might have articulated their wish for lower rates, Trump has actively tried to coerce Powell and his colleagues into doing what he wants, trying to remove Powell and another Fed governor, Lisa Cook, with transparently flimsy criminal investigations and legal actions.

He’s effectively signalled Fed officials that either they do what he tells them, or they had better have deep pockets to fund the litigation that the administration will target them with. Thankfully for Warsh, he’s worth well over $US100 million ($140 million), perhaps more than twice that amount.

Warsh, a former Fed governor during the global financial crisis, had a reputation as a monetary hawk. When campaigning for the Fed’s chair, however, he morphed into a dove, arguing that the impact of artificial intelligence on US productivity would enable higher growth rates with lower inflation and lower interest rates.

It would seem reasonable to expect that AI will increase productivity, but it is too early to say that definitively and certainly, at this point, there isn’t sufficient evidence of its impact to justify a shift in monetary policy, particularly at a time when Trump’s tariffs and the war in Iran are pushing up the inflation rate.

Even if Warsh, once in the chair – his confirmation is dependent on the vote of a Republican senator who has said he won’t support it unless the investigation of Powell is abandoned – were to convince his colleagues that lower rates are appropriate, it’s unlikely that he would satisfy Trump, who thinks the US should have the lowest rates in the world.

‘The president never asked me to predetermine, commit, fix, decide on any interest rates in any of our discussions, nor would I ever agree to do so.’

Kevin Warsh

Trump this week cited Switzerland, whose central bank policy rate is set at zero. The Swiss government has a debt-to-GDP ratio of 15 per cent and runs balanced budgets over the cycle. It is budgeting for a $US100 million surplus this year. Its inflation rate is 0.3 per cent.

The US has government debt approaching $US40 trillion, a debt-to-GDP ratio of more than 100 per cent and runs budget deficits of about 6 per cent of GDP. Its finances are on an accelerating and unsustainable trajectory. US inflation is running at about 3 per cent.

Once Warsh does become Fed chair, he will have to convince the other 11 members of the Federal Open Market Committee (FOMC), which sets US monetary policy, if he wants to lower rates.

Those colleagues might include Powell, who can remain a governor until 2028 if he chooses. He has said he won’t leave the Fed until the investigation and legal action against him have ended, and has also said he will stay on as Fed chair beyond the May 15 expiry of his term if a successor hasn’t been confirmed by then.

While the issue of the new chair’s independence is of critical importance to that of the wider Fed and its credibility with financial markets, Warsh did air some other opinions of consequence.

He is highly critical of the Fed for being able to meet its 2 per cent inflation target since the pandemic, when it thought the spike in inflation was “transitory,” doesn’t like the amount of forecasting the bank does, doesn’t like its forward guidance and the “dot plot” projections individual members of the FOMC provide for key economic data points. He also wants the Fed, which he said has lost its way and “wandered outside its remit,” to run a much smaller balance sheet.

Warsh was a supporter of the Fed’s quantitative easing programs in response to the 2008 financial crisis during his previous term as a governor, but has become a critic, saying the central bank’s interventions in markets through its bonds and mortgage buying pushed it into fiscal policy and the “business of politics.”

While the Fed has shrunk its balance sheet by more than $S2 trillion from its post-pandemic peak, Warsh argues it shouldn’t be holding large amounts ($US4.4 trillion) of Treasury securities “as if it’s the fiscal authority.”

He has said that shrinking the Fed’s balance sheet by offloading a large proportion of its Treasury securities and mortgages would allow for lower short-term interest rates, although that would probably push up the longer-term rates that influence investment activity and the borrowing rates for households.

To effect the changes in the balance sheet that Warsh wants, the levels of bank reserves held at the Fed, which have grown substantially because of the post-2008 prudential reforms requiring significant increases in bank holdings of high-quality liquidity, would probably have to be lowered (the administration is rolling back some of the 2008 reforms, including the liquidity requirements). This would raise the risk of a liquidity crisis within the US financial system.

Still, Warsh said any changes to the balance sheet (assuming he can get the rest of the Fed to agree) would be gradual and predictable “as we go through a policy regime change much more focused on interest rates.”

The more immediate change he might seek is regarding the provision of forward guidance.

The Fed, in 2008, along with all the major central banks, adopted a policy of providing that guidance, through its statements and the FOMC projections, to steer market expectations and lower long-term rates once conventional monetary policy options had been exhausted.

When the guidance turns out to be proven broadly right by events – for the Fed, the Reserve Bank and their peers it wasn’t after the pandemic – it enables businesses and households to make informed decisions on investments and borrowings.

Whether removing that guidance and letting markets, businesses and individuals come to their own conclusions produces better outcomes for the US economy is questionable – the Fed made major mistakes in the pre-guidance era, too.

Indeed, while Warsh is advocating significant changes to the way the Fed operates, the reality is that no model of a central bank will give it a Nostradamus-type ability to foretell the future.

Whether there’s guidance or not, and whether the balance sheet is big or small, central banks will still rely on data that is backward looking. And they will still have to respond to regular events that they couldn’t have predicted, like the pandemic, or Trump’s tariffs deluge, or the war on Iran.

Events will drive US monetary policies and interest rates – not Trump’s man in the Fed’s chair.

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